It's the weather. Insurance solutions to cope with the financial consequences of extreme weather

Juerg Trueb,
03 Nov 2015

Extreme weather events affect the energy industry across its whole value chain. Extreme weather events include wind storms, storm surges and floods, heat and cold waves as well as unseasonal weather such as drought or extremely high/low temperatures. The impact of extreme weather on the energy industry includes physical damages, business interruption, and fluctuations in demand or supply, and adverse effects on prices and companies’ profitability.

In particular, adverse weather impacts the production and transportation of energy, such as power lines being blown down or network functioning being disturbed. Shortages in supply and construction delays can be indirect results. Extremely high or low temperatures also affect energy production, as consumption may be higher/lower than expected, with consequent effects on earning. High temperatures affect the ability to cool thermal power plants, thus reducing their output.

All these climatic conditions will be exacerbated by climate change. The increase of global mean temperatures is thought to be the underlying cause of the changing frequency, intensity and duration of extreme weather events. Population growth and human activity have led to a significant increase in greenhouse gas emissions which, alongside with the natural climate variability, have created the global upward temperature trend. The rise in global average temperatures is disrupting the global climate system and will likely lead to shifts in the frequency, intensity and duration of extreme weather events. Human and economic exposure to the expected extreme weather events has increased, especially because of a higher concentration of people and assets (including infrastructure) in especially exposed areas like megacities and large settlement areas, which are often in coastal or flood prone areas [1]. The need to cut greenhouse gas emissions is clear. Implementation is coming through regulations, changes and subsidies. Climate policies impact decisions on future energy assets and improved energy efficiency.

Insurance provides financial coverage for risks during the life cycle of energy infrastructure. Insurance also provides financial coverage for business interruption and cash flow volatility related to extreme weather. Further risks covered include credit risks, construction and delayed start-up (e.g. due to physical damages during the construction phase a project gets delayed), physical damage and third party liability during operation as well as business interruption and income volatility as a result of the weather (e.g. no wind no power production for wind farms).

The International Energy Agency estimates the investments required to address energy demand to be around USD 48-53 trillion until 2035. Institutional investors such as pension funds and insurance companies are needed to finance these investments. However, such investors look for a steady return on investments and therefore require a robust financial risk management. Insurance companies offer a range of products in insurance and derivative form that can help to de-risk energy companies. Two examples are described below.

During drought hydroelectric companies need to substitute hydro power with power from fossil fuel driven power plants at potentially high costs. To cover such costs, hydro power producers can buy a weather contingent call option on gas (or other energy commodities needed produce power). A recent example is Swiss Re's transaction with UTE (National Administration of Power Plants and Electrical Transmissions), which is owned by the government of Uruguay. Uruguay relies largely on rainfall for its hydroelectric plants to produce enough electricity and dry conditions can lead to increased energy import at uncertain costs [2]. In a 2012 drought, this climate variability pushed the government into a deficit when Uruguay had to buy electricity on the international spot market. To help decrease this financial exposure, Uruguay's Ministry of Finance has entered into a USD 450-million weather coverage with the World Bank Treasury starting 1 January 2014. This transaction uses rainfall data and oil prices for settlement, provides the government compensation for the combined risk of drought conditions and an increase in the price of energy thereby reducing a major source of budget uncertainty each year.

Energy sales volume of gas utilities is exposed to mild winters. According to the Keppler-Chevreux Climate Change Report 2013 a 'normalization' of H1 2013 temperatures compared to H1 2012 would cause a deterioration in GDF Suez net income by EUR 236 m [3]. Utilities can cover the impact of weather and gas prices on their income by hedging both daily sales volume and prices.

[2] Hydropower is an efficient source of energy with low-carbon intensity and accounts for 17% of the world's total electricity generation. However, as with other renewables, its performance is highly dependent on the weather. Climate change makes weather increasingly unpredictable.

Author

Juerg Trueb

Juerg Trueb is Head of the Environmental & Commodity Markets team at Swiss Re Corporate Solutions. The team develops tailor-made weather and weather-contingent commodity price products which help protect energy and agricultural firms from adverse earnings caused by sales volume and commodity price risks. These solutions are available globally in the form of derivatives, insurance and reinsurance transactions.

Prior to his current role Juerg set up and managed Swiss Re’s weather & power outage and emissions trading desks. He was also previously responsible for the global agricultural and atmospheric perils units at Swiss Re. During that time he developed risk assessment and pricing tools for European windstorms, tropical cyclones and methods to steer portfolios of natural catastrophe reinsurance contracts.

Juerg holds a PhD in Atmospheric Physics from the Swiss Federal Institute of Technology and a Master's degree in Environmental Sciences.

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